Anyone who has lent a friend 20 dollars because they forgot their wallet has given a peer-to-peer loan. Peer-to-peer lending is simply a way that people with money can lend it to people who need money without going through the traditional process of depositing the money in the bank, earning interest from the bank, then having the bank lend the deposit money out at a higher rate of interest.
Today’s peer-to-peer lending systems frequently involve middlemen who aggregate investors and connect them to borrowers. Although the middleman earns profit for the role that they take, their spread is significantly less than the differential that banks charge between deposit rates and loan rates.
If you need a loan you go to the website and fill out an application just like you would have been in a normal bank. But that is not a bank lending you money. Instead, the funds come from direct investors. As you pay back the loan these investors make a return with minimum investment and it all happens at a lower cost than traditional banks.
The borrower may either be a person or a legal entity requiring financing. The rate of interest can be set by the platform or by mutual arrangement between the borrower and the lender. Fees are paid into the platform by both loans investor and also the borrower.
The debtors pay an origination fee based on their risk group and the lenders depending upon the terms of the platform need to pay an administration fee.
A number of peer to peer sites in the US has been growing constantly. Even though the industry has just been around for a few short years.
In actuality, peer-to-peer lending platforms developed mainly because banks were no longer offering loans following the financial collapse in 2008-2009. Peer-to-peer Lending websites appeared to fill that void. Peer-to-peer lending is very popular these days. After all, it is an easy way for investors to earn a decent return on their money. Actually It's the best way to make passive income.
The peer to peer sites provides the support of collecting loan payments and doing a preliminary evaluation of the debtor's creditworthiness and loan originators. The fees collected go towards the price of those services and also the overall business costs.
The platforms do not earn a gain from the spread between deposit and peer-to-peer lending rates as is the situation with ordinary financial intermediation.
There are two levels of securities regulation in the United States! The federal regulator from the SEC and State level regulators.
SEC Level Regulation
The notes being offered below this model compose a security, under the Securities Act 1933.
Therefore they have to adhere to SEC regulation. P2P lenders are expected to declare every loan they publish. These platforms are considered as public entities and for that reason, they must make public details about loan origination, investors, and debtors every month.
As a bank originates the loan, the bank, and the platform are regulated based on a number of federal statutes on credit provision, including, but not limited to: the Bank Secrecy Act, the Electronic Funds Transfer Act, the Electronic Signatures in Global and National Commerce Act, the Equal Credit Opportunity Act and the Fair Credit Reporting Act.
The Crowdfunding rules were adopted by SEC on October 30, 2015.
State Level Regulation
State level regulation changes from state to state with three major possibilities:
LendingClub was the first peer-to-peer lender to register its offerings as securities with the Securities and Exchange Commission (SEC).
Read also: Best Peer to Peer Sites In The US
As with any financial decision, there is some risk involved with peer-to-peer lending platforms. Borrowers and lenders alike must be aware of the risks associated with this innovative way of obtaining financing and how they can minimize these risks.
As those who fund the loans, lenders face the most risk in peer-to-peer lending. The most obvious risk for lenders is that borrowers will not pay the money back. With rare exceptions, there is never an absolute guarantee that the lender will get all of his or her money back when he or she makes a loan.
A careful examination of any available data about the borrowers and their financial situations will help you select low-risk borrowers. Using a third-party peer-to-peer lending company or website that has some sort of vetting process for its borrowers can also help you separate those who are likely to repay their loans from those who are likely to default.
Another risk that lenders face is that the loans they decide to fund may not actually go through. Individual lenders often contribute only a portion of the funds for a peer-to-peer loan because peer-to-peer loan facilitators allow lenders to pool their resources on one loan and lower their overall lending risk.
If a person wants to borrow $1,000, for example, ten different lenders may have to put in $100 each for the loan requirements to be met and the funds to be disbursed to the borrower. You might find a loan that you are interested in as a lender but that you do not want to fund in its entirety.
If enough lenders do not contribute funds to the loan, it will not go through, and you will see no return on your money. On the other hand, you will not have lost anything either.
One way to help ensure that you fund only loans that will actually go through to the borrower is to make a larger contribution to the pool of funds that are being set aside for the loan. Of course, you can also decide to fund loans in their entirety yourself, but that is a riskier move.
You might think that borrowers do not face many risks when they choose peer-to-peer lending. It is true, of course, that their financial risks are lower than the risks lenders take on in the loan process. Nevertheless, there are dangers and hurdles that borrowers face in peer-to-peer lending.
Although borrowers with poor credit are more likely to get a peer-to-peer loan than they are to get a traditional bank loan, it is still possible that no peer-to-peer lender will want to fund your loan if you are considered a high-risk borrower.
Furthermore, the larger the loan requested, the more likely it is that lenders will refuse the loan. Borrowers can reduce this risk if they request smaller amounts of money and also provide a lot of information about their financial situation to potential lenders in the loan request.
Taking out several smaller peer-to-peer loans and paying them back quickly can also build up your reputation and make lenders feel better about extending a loan to you.
There is also the risk that the only loans you as a high-risk borrower might get are those that have an extraordinarily high interest rate. Again, the best way to avoid this is to demonstrate that you are not a high-risk borrower through the rapid repayment of several smaller loans.
All in all, peer-to-peer lending can be a great way for both lenders and borrowers to meet their respective needs. Just be aware of the risks so that you can work to minimize them when you make or receive a peer-to-peer loan.
Borrowers approach a peer-to-peer lender just as they would any other lender. Many lenders will require borrowers to provide a credit score to prove their creditworthiness. Assuming that the borrower meets the lender’s standards, they will execute a promissory note and, potentially, a security document to collateralize the loan.
Once they have signed off, the lender will give them the money and they will commence making monthly payments.
The variety of platforms within the Peer-to-Peer market means the comparison is not a straightforward exercise and understanding the myriad different business models is a challenge.
Even in the best economic times, getting a good return on your savings is necessary to beat inflation and retain the value of your money over time. Traditionally, investing in the stock market has been one of the best ways to earn an excellent rate of return.
Many people have used their hard-earned funds to buy positions in individual companies. Others have bought shares of mutual funds in order to spread the risk among several investments.
Investing in the stock market does have its advantages, but it is not necessarily the best way for every person to grow his or her savings over time. Returns are hardly guaranteed, and it can take a lot of knowledge to beat the market’s average annual return, which is about ten percent over several decades.
Read also: Peer to Peer Lending Vs Stocks
Yet there is a way to increase your odds of getting even better returns when you invest your money. You can invest your funds via peer-to-peer lending and get a handsome return on your investment.
Peer-to-peer lending is a relatively new way of investing that has developed with the spread of Internet access. In peer-to-peer lending, you lend money directly to other people, often through a third party such as an Internet lending company.
In many cases, you are free to set the terms and interest rate yourself. At other times, you agree to terms that the borrower suggests. You need not fund the entire amount that the borrower is seeking, for third party sites often allow you to pool your money with others in the same loan, which spreads the risk.
In any case, there are many advantages to peer-to-peer lending as an investment.
First, the amount of research it takes to be a successful peer-to-peer lender is much less than what is required to be a great success in the stock market. To judge accurately whether a company is a good investment or not, you have to understand balance sheets, know the position of the company in relation to its competitors and much more. Becoming adept at this can take years, if not decades.
On the other hand, much less research is required to earn a good return through peer-to-peer investing. When you make such loans through a third party site, you usually have access to data such as the borrower’s credit history, income and so on. All of these facts are easy even for those with little background in finance to understand.
You can make a decision relatively quickly as to whether you should agree to an individual’s loan terms or not, making it easier to choose which loans deserve your investment than it is to pick the right stocks.
The second advantage of peer-to-peer lending is the potential for a fabulous return. Many borrowers are willing to pay more than a ten percent rate of interest because they have been unable to obtain a loan elsewhere. It is impossible to get anywhere near this return in a traditional CD or savings account, and it is hard even to get this rate when you invest in the stock market.
Read also: How Much Do You Make With P2P lending?
A third advantage of peer-to-peer lending is that you can start investing with only a small amount of money. Many brokerages and banks require a minimum amount before you can open an account. This minimum can be upwards of $500 or more.
But with peer-to-peer lending, you can get a piece of the action with as little as $50 or less when you work through a third party company that bundles many investments into larger loans. You need not wait until you have a lot of cash to earn a return on your money when you choose peer-to-peer lending.
Peer-to-peer loans can be riskier than other investments, but you can offset this risk and maintain a great return by spreading the money you lend across several loans and borrowers. Thus, peer-to-peer lending becomes a safer way to enjoy a greater return.
Peer-to-peer lending is a relatively new way of investing, but it is one that has great potential to give you the best returns on your money. Consider these advantages carefully, and you will no doubt see how wise the right peer-to-peer loan investment can be for your portfolio.
Peer-to-Peer lending is an excellent way both for investors to get returns and for borrowers to access debt markets. For both parties, though, it has tax implications that can make it different from other investments.
For a peer-to-peer lender, the interest that they receive is taxed as regular income. So, if a person making a loan falls into the 25% bracket, they would have to pay 25% of the interest that they receive in Federal income taxes. This puts peer-to-peer lending at a disadvantage relative to stock investing which receives preferable tax treatment for both capital gains and dividend income.
The tax consequences of peer-to-peer lending are less serious than they seem, though. With typical peer-to-peer lending returns in the neighborhood of 10 percent per year, even after the higher taxes they outstrip what the stock market delivers.
In addition, savvy investors can use money in a Roth Individual Retirement Account (IRA) to engage in peer-to-peer lending. Since money in a Roth grows on a tax-free basis, the taxation penalty applied to the interest is negated.
Alternately, they could use a traditional IRA to engage in peer-to-peer lending. While this does not eliminate the tax penalty, it defers it until the funds are withdrawn from the IRA, letting the money work harder while it is being lent.
For a peer-to-peer borrower, a loan is just like any other loan for tax purposes. If they are using the loan to repay personal debt, it would be treated like any other personal loan and would not be deductible. On the other hand, the interest paid on a loan for business start-up costs could be written off by the business.
Interest on peer-to-peer loans structured as mortgages or second mortgages would also be deductible if they met the same standards as a bank-originated mortgage, although the lender will need to file the appropriate 1098 form with the Internal Revenue Service to report the interest received.
The tax information here applies to peer-to-peer loans made to unrelated parties. When a loan gets made between related parties, such as from mother to daughter, the Internal Revenue Service can treat the loan differently.
In fact, it is possible that the lender would have to report the income while the borrower could not claim the interest as a deduction, even if they were entitled to it. Parties involved in peer-to-peer transactions with related people should consult an accountant for guidance.
Ultimately, peer-to-peer lending is an excellent option for both borrower and lender. From a tax perspective, it is no different from any other loan for the borrower. While it is different from other investments from a lender’s perspective, good tax strategy can help to maximize the already-generous returns from this investment class.
As the economy slowly heals from the damage of the backlash of the recession and resultant issues brought on by shady lending practices, more borrowers will turn toward P2P lending as a way to avoid the high-interest credit cards and other loans that present a hurdle to getting themselves out of debt.
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